Federal Income Taxation of Partnership & Corporation Outline PDF

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Corporate & Partnership Tax Outline

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OVERVIEW OF BUISNESS ENTERPRISE a .Categories of Businesses i .Partnerships 1 .Partnership = a business owned by two or more persons as co-owners a .Includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate. [§ 706(a)]. 2 .Subchapter K 3 .General Partnerships a .All partners have unlimited liability for the businesses debt 4 .Limited Partnerships a .The limited partners are protected from personal liability b .The General Partner has unlimited liability for the businesses debt 5 .Limited liability Partnerships a .All members are protected from liability for the businesses debt 6 .Limited Liability Company a .Unincorporated entity in which the owners, called “members” have limited liability i i .C Corporations 1 .Subchapter C 2 .Large Businesses, publically traded corporations 3 .Has a Double Tax Regime i i i .S Corporations 1 .Subchapter S 2 .Smaller corporations; do very little business b .Conceptual Taxation Models i .Aggregate Concept 1 .A partnership would not be recognized as an independent taxable entity. Each of the partnership owners holds a direct undivided interest in the assets and operations of the enterprise 2 .The partnerships income and deductions would be treated as directly earned or incurred by the partners 3 .Distributions would be nontaxable because the partners would be viewed as receiving income, which was previously taxed. i i .Entity Concept 1 .Would resemble the treatment of corporations in Subchapter C. 2 .A business organization is viewed as an entity that is separate and distinct from its owners. 3 .Entity is subject to tax on its taxable income, and transactions between the owners and the entity are taxable events (double tax). a .Distributions of corporate profits are taxable to the Shareholders. i i i .Hybrid Concept 1

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1 .Treating an organization as a separate entity for some purposes (determining income, filing of tax returns), and as an aggregate for other purposes (passing through income and expenses to owners and by treating a sale of an interest in the organization as a sale of the owner’s proportionate share of each asset). En t i t yCl a s s i fic a t i o n a .Cho i c e s i .So l ePr o p r i e t or s h i p i i .Co r p o r a t i o n 1 .Ge n e r a l l y ,s h a r e h o l d e r sa ndn o tp e r s o n a l l yl i a b l ef o rCo r psd e b t s 2 .Do u b l et a xr e g i me a .Ta xi mp o s e do nb o t ht h eCor p o r a t i o na n dSh a r e h o l de r i i i .Pa r t ne r s h i p 1 .Ge n e r a lPa r t n e r s h i p 2 .Li mi t e dPa r t n e r s hi p 3 .Li mi t e dLi a b i l i t yPa r t n e r s h i p 4 .Li mi t e dLi a b i l i t yComp a n y a .Li mi tl i a b i l i t ya n du s es i n g l et a xr e g i me i v .Di ffe r e n c e s 1 .Li a b i l i t y a .Co r p s g e n e r a l l yn o tp e r s o n a l l yl i a b l e b .Pa r t n e r s h i ps s o mema yb ep e r s o n a l l yl i a b l e 2 .Fe d e r a li n c o met a x a .Co r p s Do u b l et a xr e g i me i .Se c t i o n1 1 i i .I n d i v i d u a lr a t e sa r eh i g he rt h a nc a p i t a lg a i nr a t e s b .Pa r t n e r s h i ps Si n g l et a xr e g i me v .Wa y st or e d u c eCo r p o r a t el e v e lt a x 1 .El i mi n a t ec o r p o r a t ei n c o meb yg i v i n gs a l a r i e s 2 .Do n ’ tc h o o s ead o u b l et a xr e gi me v i .Wa y st or e d u c eSh a r e h o l de rt a x 1 .Ho l ds t o c kun t i ld e a t h b .Cl a s s i fic a t i o ni nqui r y Wa yt ot e l lwhi c ht a xr e g i mea ppl i e s ,de pe ndsona ns we rt o2 que s t i o ns : i .I st he r eas e pa r a t ebus i ne s se nt i t y ? 1 .Co r p o r a t i on s 2 .LP ,GP ,LLC 3 .Ke yf a c t o r sr e q ui r e df o rs e p ar a t ee n t i t ys t a t u s( Po d e l l ) : a .Co n d uc t e df o rp r o fit b .Sh a r ep r o fit sj o i n t l y i .Ag r e e me n tt os h a r ee xp e n s e sn o te n o ug h c .Asp r o p r i e t or s( o wn e r s ) 4 .Wha ti sno tas e p a r a t eb u s i n e s se n t i t y ? a .Me r ee x pe n s es h a r i n g b .Me r ec o o wn e r s hi p c .Me r el e a s e i i .I ft he r ei sas e pa r a t ebus i ne s se nt i t y ,i st hee nt i t yt a x e da sac o r po r a t i o no rpa r t ne r s hi p? 1 .Fa c t o r su s e di nt h eo l dt e s tf o raCo r p o r a t i on a .Co n t i n u i t yo fl i f e 2

b .Ce n t r a l i z e dma n a g e me n t i .Cor p Bo a r d i i .Pa r t n e r s h i p Ag e nt s c .Li mi t e dl i a b i l i t yf o ro wn e r s d .Fr e et r a n s f e r a b i l i t yo fi n t e r e s twi t hn oe ffe c tont h ee n t i t y 2 .I n1 9 9 7 ,e n t i t yc l a s s i fic a t i o nb e c a mee x p l i c i t l ye l e c t i v e a .Che c kt hebo xr e g ul a t i o ns i .Ap p l yo n l yt oe n t i t i e st h a ta r et r e a t e da ss e pa r a t ef r o mi t so wne r s i i .Do me s t i ce n t i t i e s 1 .I fe n t i t yi saCo r po r a t i o ni n c o r p o r a t e dun d e rt h ef e d e r a lo rs t a t e s t a t u t e ,c l a s s i fie da sac or p o r a t i o n a .I fy e s ,t a x e da sc o r p o r a t i o n b .I fn o( u n i n c or p o r a t e d ) ,de p e n d so nh o wma n yo wn e r s i .2o rmo r eo wn e r s t r e a t e da sp a r t n e r s h i pf o r t a xp u r p o s e s i i .1o wne r t r e a t e da sadi s r e g a r d e de n t i t yf o rt a x p u r po s e s( LLC) 2 .Un i n c o r p o r a t e de n t i t i e ss t i l lh a v et h ec h o i c et oe l e c to u ta n db e t r e a t e da sac o r p or a t i o n i i i .Fo r e i g ne n t i t i e s 1 .I nt h ea b s e n c eo fs p e c i ficj xn ss t a t e di nr e gu l a t i on ,f o r e i g n e n t i t i e sa r ec l a s s i fie da s a .Ap a r t n e r s h i pi ft hee n t i t yh a st woo rmo r eme mb e r s a n da tl e a s to n eme mb e rd o e sn o th a v el i mi t e dl i a b i l i t y b .Ana s s o c i a t i oni sa l lme mb e r sh a v el i mi t e dl i a b i l i t y c .Di s r e g a r d e da sa ne n t i t ys e p a r a t ef r o mi t so wne ri ft he e n t i t yh a sas i n gl eo wn e rt h a td o e sn oth a v el i mi t e d l i a b i l i t y . i v .Thi sa l l o wsp e o p l et oc ho o s et h ewa yt h e i re n t i t i e sa r et a x e d c .“Check the Box” Regulations i .Step 1: Separate Entity 1 .Is the activity/entity an entity separates from its owners? a .If not, it is not subject to classification regulations b .If yes, move on to the next question 2 .Requires a “jointness” in at least some decision making, income or profits, or both a .Mere sharing of income is insufficient to create an entity. 3 .Activity must rise to the level of business, financial operation or venture. i i .Step 2: Business Entity 1 .Is the entity regarded as a business entity? a .NOT a trust or subject to special treatment  If not a business entity then it is a trust, or is subject to special tax treatment b .If yes, then move on to next question i i i .Step 3: Eligible Entity 1 .Is the entity an eligible entity under Reg. §301.7701-3(a)? a .Is it classified as a corporation? i .If yes, the entity is a corporation for federal tax purposes and is taxed under Subchapter C or S 3

i i .If no, move on to next question i v .Step 4: Number of Members 1 .Does the entity have two or more members? a .If yes, the entity can elect to be a partnership OR a corporation b .If no, the entity can elect to be a corporation or disregarded for federal tax purposes 2 .Default Rules: a .2 or more members  treated as a partnership b .1 member  disregarded entity 3 .Note  an eligible entity that chooses to be an S corporation automatically is treated as making the election to be a corporation d .Problem – pg. 22 i .Which of the following relationships to constitute a separate entity for federal tax purposes? 1 .A, B and C purchase a single parcel of land as tenants-in-common and hold the land as an investment. a .Not a Separate Business Entity  mere co-ownership 2 .Same as above, except the land is subdivided and A, B and C sell the lot a .Separate Business Entity  they are selling the lots and sharing the profits 3 .Litigator and Negotiator are attorneys who share an office and a secretary. Each attorney services and bills his own individual clients. a .Not a Separate Business Entity  just sharing expenses PARTNERSHIPS PART I -- DETERMINATION OF TAX LIABILITY a. §701. Partners, Not Partnership, Subject to Tax b. §702. Income and Credits of Partner c. §703. Partnership Computations d. §704. Partner’s Distributive Share e. §705. Determination of Basis in Partnership’s Interest f. §706. Taxable Years of Partner and Partnership g. §707. Transactions Between Partner and Partnership h. §708. Continuation of Partnership i. §709. Treatment of Organization and Syndication Fees PART II -- CONTRIBUTIONS, DISTRIBUTIONS, AND TRANSFERS j. Subpart A -- Contributions to a Partnership i. §721. Nonrecognition of Gain or Loss on Contribution ii. §722. Basis of Contributing Partner’s Interest iii. §723. Basis of Property Contributed to Partnership iv. §724. Character of Gain or Loss on Contributed Unrealized Receivables, Inventory Items and Capital Loss Property k. Subpart B -- Distributions by a Partnership i. §731. Extent of Recognition of Gain or Loss on Distribution ii. §732. Basis of Distributed Property Other Than Money iii. §733. Basis of Distributee Partner’s Interest iv. §734. Adjustment to Basis of Undistributed Partnership Property Where Section 754 Election or Substantial Basis Reduction 4

v. vi. vii. viii.

§735. Character of Gain or Loss on Disposition of Distributed Property §735. Character of Gain or Loss on Disposition of Distributed Property §736. Payments to a Retiring Partner or a Deceased Partner’s Successor in Interest §737. Recognition of Precontribution Gain in Case of Certain Distributions to Contributing Partner

l. Subpart C --Transfers of Interests in a Partnership i. §741. Recognition and Character of Gain or Loss on Sale or Exchange ii. §742. Basis of Transferee Partner’s Interest iii. §743. Special Rules Where Section 754 Election or Substantial Built-in Loss m. Subpart D -- Provisions Common to Other Subparts i. §751. Unrealized Receivables and Inventory Items ii. §752. Treatment of Certain Liabilities iii. [§753. Partner Receiving Income in Respect of a Decedent] [not covered] iv. §754. Manner of Electing Optional Adjustment to Basis of Partnership Property v. §755. Rules for Allocation of Basis PART III – DEFINITIONS- §761. Terms Defined

I I I . CONTRIBUTIONS OF PROPERTY a .Overview i .Partnership 1 .G/L: §721(a)  none recognized 2 .AB: §723 inside basis  takes partner’s basis in the assets 3 .HP: §1223(2)  carry over from partner i i .Partner 1 .G/L: §721(a)  none recognized 2 .AB: §722 outside basis amount of money contributed, and the AB of property contributed 3 .HP: §1223(1)  tacking (carryover) basis for 1221 capital assets and 1231 assets b .§ 721 – Nonrecognition of Gain or Loss on Contribution i .Gain or loss is not recognized by either a partnership or its partners on a contribution of property to the partnership in exchange for a partnership interest. 1 .Applies to BOTH newly formed and existing partnerships. [Reg. § 1.721-1(a)] i i .Principal requirement is the partner must receive interest in exchange for PROPERTY 1 .Property includes: a .Cash b .Inventory c .Accounts receivable d .Patents e .Installment obligations f . And other intangibles such as goodwill and industrial know how. i i i .§ 721(a) does NOT apply to transactions between a partnership and a partner not acting in the capacity of a partner. 1 .Example  If a partner sells or leases property to the partnership, the transaction is NOT governed by § 721 i v .§ 721(a) overrides the depreciation recapture provisions of § 1245(b)(3) and § 1250(d)(3). 1 .The potential recapture income is preserved in the partnership’s basis in the asset. 5

v .§ 721(b)  Subsection (a) shall not apply to gain realized on a transfer of property to a partnership, which would be treated as an investment company if the partnership were incorporated. c .§ 722 & § 723 – “Outside” and “Inside” Basis i .§ 722 OUTSIDE Basis = the sum of the money and the adjusted basis of the property contributed to the partnership 1 .Partner’s basis in his partnership interest i i .§ 723 INSIDE Basis = the basis the contributing partner had in the partner. 1 .Partner’s basis in its assets 2 .Both the contributing partner and the partnership obtain a basis INCREASE if gain is recognized under the investment partnership rule in § 721(b). i i i .TOTAL OUTSIDE BASIS = TOTAL INSIDE BASIS 1 .There are exceptions d .Holding Period i .The period a partner held contributed property is tacked to the holding period of a partnership interest if: 1 .The partnership interest has the same basis as the property contributed 2 .The property exchanged was a capital asset or § 1231 property. [§ 1223(1)] a .Capital Asset = includes everything (land, machinery, equipment, vehicles, furniture, buildings) i .Does NOT include: Inventory, depreciable property or real property used in trade or business, supplies used in trade or business, property held for sale to customers in the ordinary course of trade or business i i .If contributed property consists of cash or ordinary income assets, the holding period begins on the date of exchange e .Revenue Ruling 99-5 i .Situation 1 1 .In this situation, the LLC, which, for federal tax purposes, is disregarded as an entity separate from its owner, is converted to partnership when the new member, B, purchases an interest in the disregarded entity from the owner, A. 2 .B’s purchase of 50% of A’s ownership interest in the LLC is treated as the purchase of a 50% interest in each of the LLC’s assets, which are treated as held directly by A for federal tax purposes. a .Immediately thereafter, A and B are treated as contributing their respective interests in those assets to a partnership in exchange for ownership interest in the partnership. 3 .Under § 1001  A recognizes gain or loss from the deemed sale of the 50% interest in each asset of the LLC to B. 4 .Under § 721(a)  no gain or loss is recognized by A or B as a result of the conversion of the disregarded entity to a partnership 5 .Under § 722  B’s basis in the partnership interest is equal to $5,000, the amount paid by B to A for the assets, which B is deemed to contribute to the newly created partnership. a .A’s basis in the partnership interest is equal to A’s basis in A’s 50% share of the assets of the LLC.

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6 .Under § 723  the basis of property treated as contributed to the partnership by A and B is the adjusted basis of that property in A’s and B’s hands immediately after the deemed sale. i i .Situation 2 1 .The LLC is converted from an entity that is disregarded as an entity separate from its owner to a partnership when a new member, B, contributes cash to the LLC. B’s contribution is treated as a contribution to a partnership in exchange for an ownership interest in the partnership. 2 .A is treated as contributing all of the assets of the LLC to the partnership in exchange for a partnership interest. 3 .Under § 722  B’s basis in the partnership interest is equal to $10k, the amount of cash contributed to the partnership. a .A’s basis in the partnership interest is equal to A’s basis in the assets of the LLC which A was treated as contributing to the newly created partnership. 4 .Under § 723  the basis of the property contributed to the partnership by A is the adjusted basis of the property in A’s hands. The basis of the property contributed to the partnership by B is $10k, the amount of cash contributed to the partnership. f . Problem pg. 46-47 i .A, B, C and D form a general partnership in which they each have an equal interest in capital and profits. All the partners and the partnership are cash method taxpayers. In exchange for their respective partnership interest, each partner transfers the following assets, which have been held more than 2 years: Partner Asset Adjusted Basis Fair Mkt. Value A Land $30,000 $70,000 Goodwill 0 30,000 B Equipment (all § 1245 gain) 45,000 25,000 Installment note from the sale of land 25,000 20,000 30,000 5,000 Inventory C Building 25,000 60,000 Land 25,000 10,000 Receivables for services rendered to E 0 30,000 D Cash 100,000 100,000 1 .What are the tax consequences to each of the partners? a .Realized Gain/Loss = AR – AB i .A: $100k - $30k = $70K  NOT RECOGNIZED under § 721(a) i i .B: $100k - $50k = $50k Realized NOT Recognized i i i .C: 90K (not land) - $25k = $65k Realized NOT Recognized i v .D: $0 gain or loss realized b .Outside Basis i .A = $30 i i .B = $25k + $20k + $5k = $50k i i i .C = $25k + $25k = $50k i v .D = $100k c .Holding Period 7

2 .What are the tax consequences to the partnership? a .Gain Recognized to Partnership i .§ 721(a)  No gain/loss recognized to partnership for contribution of property in exchange for partnership interest b .Inside Basis i .§ 723  Basis of contributed property = AB to partner at contribution 1 .$30k + 50k + 50k + 100k = $230k Inside Basis 3 .§ 704(c)(1)(A)  Requires the partnership to allocate the precontribution gain or loss solely to the contributing partner when the partnership subsequently disposes of the property. a .The objective of this section is to disallow partners from assigning income to partners who did not hold the asset. D in this situation just contributed cash, so he can’t earn anything. I V. PARTNERSHIP ACCOUNTING a .Balance Sheet i .Left Side (“Book Value”) 1 .Partnership assets are listed starting with the most liquid. 2 .Both the AB (inside basis) and the FMV of each asset are listed. a .Book Value does not change until some event occurs that warrants a revaluation of Partnership assets b .AB = Partnership’s basis in each asset c .FMV = value of asset upon contributions, minus depreciation that has been taken by the partnership i i .Right Side (“Capital Accounts”) 1 .Represents a partner’s equity in the partnership. a .Capital Account = Identifies what each partner would be entitled to receive upon liquidation when the partnership sells assets at book value, pays creditors off, and distributes net proceeds to the partner. i .Capital Accounts INCREASE for [Reg. § 1.704-1(b)(2)(iv)(b)]: 1 .Contributions of money by partner 2 .FMV of property contributed by partner 3 .Allocation of income in gain, loss, and deduction i i .Capital Accounts DECREASE for [Reg. § 1.704-1(b)(2)(iv)(b)]: 1 .Money distributed to partner by partnership 2 .The FMV of property distributed to the partner by the partnership 3 .Partnership shares of a partner’s loss and deduction b .Distributive Share i .Absent an Agreement, the Uniform Partnership Act provides that profits will be shared equally 1 .Partners frequently will agree to allocate profits in proportion to their respective interests in partnership capital. c .Problem – pg. 53 i .A, B and C are equal general partners in the ABC Partnership. On formation of the partnership, A contributes $50,000 cash, B contributes land (Parcel #1) with a basis of $40,000 and a fair market value of $50,000, and C contributes securities with a basis and fair market value of $50,000. Prepare the partnership’s opening balance sheet and then 8

reconstruct the balance sheet to account for each of the following (cumulative) subsequent events Assets Liabilities and Partner’s Capital Assets Adjusted Book Tax Book Basis Value Capital Value Cash $50k $50k Liabilities: None Parcel #1 $40k $50k Capital: Securities $50k $50k A $50k $50k B $40k $50k C $50k $50k $140k $150k $140k $150k 1 .The partnership leases Parcel #1 for $15k and sells the securities for $50k. a .$15k/3 = $5k to each partner b .$50k goes into cash + $15k for the lease Assets Liabilities and Partner’s Capital Adjusted Book Tax Book Basis Value Capital Value Cash $115k $115k Liabilities: None Parcel $40k $50k Capital: #1 A $55k $55k B $45k $55k C $55k $55k $155k $165k $155k $165k 2 .The partnership borrows $300k and then buys more land (Parcel #2) for $330k. a .Borrow $300k  Increase Liabilities to $300k b .Buy Parcel #2 for $330k  Decrease cash by $330k i .$330k for the land - $300k borrowed = $30k i i .$115k - $30k = $85k c .Borrowing money does NO...